Budgeting basics - Part II: Creating your budget

Last week we learned about setting up goals for your budget. This week we begin with a discussion about how to calculate the cost of your goals, and then we get busy creating the actual budget.

Calculate the Annual Cost of Each Goal

Now that you’ve listed all of your financial goals and broken them out by when you expect to achieve those goals, it’s time to determine the actual cost for each goal and the years in which you expect to meet that cost. Some goals may be funded in the year in which you plan to meet that goal, other goals may require saving for one or more years.

For example, if you plan to purchase a new car in two years and you want to have a down payment of $3,000 when you make the purchase, you may be able to fund that down payment out of your current savings in year two. If you don’t expect to be able to put aside $3,000 for your car in year two, you need to split the down payment between years one and two, and save $1,500 each year, or $125 each month. Write down next to the car how much you need to put aside each year, and also write down how much you expect your monthly payments to be when you actually purchase the car and the number of years over which you plan to finance the car.

Creating a Budget

You’ve determined what your financial goals are and when you expect to meet those goals. Now it’s time to analyze your current income and expenditures and create a working budget that enables you to achieve those goals.

An annual budget lists all of your anticipated income and cash outlays for a year. At the beginning of each year, create a budget for the year based on the information you compile in this lesson.

Analyze Your Income

List all the areas from which you plan to derive income and how much you expect to receive for the coming year. Your income may be in the form of wages from your and your spouse’s job, interest earned on savings, child support payments, rent, inheritance, gifts, and tax refund.

List only the amounts you actually receive. In the case of your job, list the amount you take home on your paycheck, not the gross amount you receive. If your salary is $40,000, but you only take home $31,000 after taxes and other withholdings, list $31,000 as your income from your job.

For now, don't include other sources of cash such as borrowing, using your emergency fund, or liquidating assets. As you fine-tune your budget you can add the money from these sources in order to meet your financial goals. Right now, however, find out how much your income will cover, what kind of shortfall exists, and then you can analyze how to meet that shortfall, either by augmenting your revenue or cutting your expenses.

Analyze Your Expenses

List all of the areas where you spend money and how much you expect to spend during the coming year. Include items such as housing expenses, utilities, food, medical expenses, childcare, transportation, clothing, insurance, dues, education, debt repayment, charity, and savings. Include a category for cash allowances and miscellaneous spending.

You may need to spend a month or two carefully tracking how your money is spent. If you like to carry cash and spend money from your wallet instead of tracking your expenses by writing checks or using a debit or credit card, you probably don’t have a clear picture of where all your money is spent. Carry a small notebook with you and write down everything you spend your money on. A simple spiral notebook works well for recording your spending activities.

When determining your budgeted expenses, a good rule of thumb is to allow 65% of your take-home pay for regular monthly expenses such as housing, food, utilities, transportation. Set aside 20% for occasional expenses such as clothing, repairs, books, and fun. Designate 10% for non-monthly payments such as insurance, and use the remaining 5% (or more, if possible) for savings and investments. Self-employed people need to remember to budget for income tax, Social Security (self-employment) tax, and Medicare tax.

When setting aside money for savings, you need to place some money in liquid investments that you can access readily, and other money in long-term investments that you can leave alone to grow.

Break Down Your Budget by Month

Prepare a separate column for each month of the coming year, then divide each income and expense item by 12 and list the result in each monthly column. You may know of some income and expense items that change or vary from month to month, but for now just enter the same amount in each monthly column. For example, you may pay life insurance once a year, let's say in April. You could put the entire amount of life insurance expense in your budget for April and nothing in any other month. For this exercise, however, put one twelfth of your life insurance expense in each month instead of the entire amount in April.

Total each column to determine how much money you have left each month after all your expenses have been met. If your expenses exceed your revenue, don't worry. You still have some fine-tuning to do to get your budget to a workable state.

Fine Tune your Budget

Look over the amounts you budgeted and determine the accuracy of each amount. If some amounts vary from month to month, or if some amounts change during the year, you can adjust the amounts in your budget to reflect the reality of your finances.

Certain amounts that may only occur once or twice a year, such as insurance payments, can be entered in full in the months they occur or can be spread over twelve months in order to help you save for these outlays. For example, if you make a $600 term life insurance payment once a year in July, you can place the entire $600 in your July column. But from a budgeting standpoint, a better approach is to set aside $50 each month to save for this payment. That way the payment becomes just another monthly expense and not a budget-buster.

If you expect to receive a raise at your job during the year, or if you expect to start a new job later in the year, enter the change in your income in the month when the raise takes place.